Deloitte’s hand everywhere, Nortel trial hears

TORONTO • Nearly three months into the accounting-fraud trial involving Nortel Network’s top three financial executives, proceedings have slowed to a crawl. The reason is obvious. The Crown has been going over the same ground again and again, all the while failing to address a central problem with its case.

The conundrum is this: Nortel’s independent auditors, Deloitte, appear to have signed off on every accounting transaction the Crown alleges was fraudulent.

This is true even of accounting entries that appear on the surface to look decidedly odd. This week the Toronto courtroom of Justice Frank Marrocco listened to Linda Mezon — a former assistant controller at Nortel — dissect some very late accounting transactions that closed the books on the company’s final quarter of 2002.

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The details are complex but the gist is straightforward. Just days before the company was due to issue a press release showing a $62-million quarterly loss, Nortel’s finance group determined it should have recognized a $25.5-million loss arising from one aspect of the sale of its optical components business in November 2002. However, rather than simply adding that figure to the $62-million loss, Nortel booked an identical, offsetting gain of $25.5 million by adjusting its assumption about how much of its inventory was obsolete. This, too, was very last minute. The result: the loss for the quarter remained at $62 million.

The conundrum is this: Deloitte appear to have signed off on every accounting transaction the Crown alleges was fraudulent

Mezon testified this week that she had been surprised to discover that her then-boss, controller Michael Gollogly, had approved the offset. And Crown prosecutor Robert Hubbard early on singled out this transaction as a prime example of earnings manipulation he claimed had been orchestrated by the co-accused — chief executive Frank Dunn, chief financial officer Douglas Beatty and controller Michael Gollogly.

Hubbard noted in his opening statement that Nortel had booked nearly $1 billion worth of liabilities in connection with inventories it considered were in excess or obsolete. “Because (these) accounts were huge and it was difficult to determine inventory’s true value, the account’s amounts could be easily manipulated,” he told the court. “The accused resorted to these accounts as a ‘cookie jar’ to hit earnings targets,” he added.

However, Mezon — a Crown witness — suggested this week that something more benign was at play. She noted that Nortel had just emerged from a very punishing period during which two out of every three colleagues had been sacked, offices were closed and hundreds of contracts with suppliers had been broken. The demands on the firm’s accountants in particular had been heavy. Despite all these distractions, Nortel’s finance group had prepared a very complex set of financial numbers for the fourth quarter and had been set to release them.

“The purpose of the offset was so we didn’t have to change all the documents,” Mezon told the court.

Ken Crosson — the manager in charge of the excess and obsolete inventory file — had ultimately approved the last-minute change. Mezon testified that Crosson had assured her he was able to justify it in accounting terms. Not only that, Mezon added, she and her colleagues had concluded the $25.5-million transaction wasn’t material — that is, significant to earnings. “If it had been, I would have looked at it more closely,” she said.

At the time, Nortel had roughly 4.3 billion shares outstanding, which meant that the last-minute adjustment to earnings amounted to little more than half a penny per share. And whether the entry had been made or not, Nortel would have posted a loss for the quarter.

Mezon added that she did one other thing: “I made sure the auditors knew.” Defence lawyer David Porter in January entered an exhibit showing that Deloitte approved the entry.

In retrospect, the decision to book an identical $25.5-million offset to avoid more paperwork looks like sheer expediency, born of exhaustion. To suggest, as the Crown has done, that this is evidence of earnings manipulation seems a stretch. If you were conducting a criminal conspiracy, you would at least try to cover your tracks by using less obvious accounting entries.

Mezon — now chief accountant at the Royal Bank of Canada — also shed light on a suspicious looking email she had sent to her colleague Brian Harrison nearly two weeks before the close of the fourth quarter for 2002. In it, Mezon noted that Nortel CFO Doug Beatty was “most concerned” about the excess and obsolete accounting. “Can we look at this next week,” Mezon wrote, “and then I can get Helen (Verity, Nortel’s director of consolidations) to move provisions around as needed. Apparently this is straight from FAD (Frank Dunn).”

At first blush, Mezon appears to have been suggesting that her colleague, Helen Verity, was free to shift accounting entries according to Dunn’s wishes. However, Mezon testified this week under cross-examination by Porter that she meant something different. Since the entry in question involved the sale of a Nortel business unit, Mezon’s concern was that the related accounting was done in the correct categories — under continuing or discontinued operations, for instance.

“We had to make sure it was in the right segment,” she told Porter this week.

What emerges from the trial to date — so far, nine of Nortel’s mid-level finance employees have testified — is a portrait of executives coping as best they could with an unprecedented collapse of company revenues. The finance group, it is clear, made mistakes. The defence maintains these were honest ones, and were dealt with through the proper accounting channels.

That Nortel’s finance group discussed these issues openly with Deloitte is also clear from the hundreds of emails so far introduced into evidence. There appears no effort on the part of Nortel’s finance group to hide difficult accounting issues from Deloitte. The auditors’ lengthy history with many of the allegedly fraudulent accounting transactions is evident in a March 15, 2004, memo prepared by Deloitte auditor Karen Keilty.

This document, entered into evidence in January but buried along with hundreds of other exhibits, refers to a review of accounting provisions prepared by Deloitte in connection with its 2002 audit of Nortel. Included in this list are many of the line items — more than $300 million worth — that the Crown alleges made up Nortel’s infamous “cookie jar.” The significance of the list lies in its timing. If Deloitte knew about the accounting issues this early, then gave a positive opinion about the transactions throughout 2003, then where is the Crown’s case that fraud occurred?

That question will undoubtedly absorb the court’s attention on May 14, when — finally — at least two senior Deloitte executives are scheduled to testify. Meantime, Judge Marrocco will hear arguments April 17 and 18 about whether notes taken by Frank Dunn’s lawyers early in 2004 are admissible. Dunn at the time was being interviewed by Wilmer Cutler lawyers — who had been hired to provide an outside opinion on Nortel’s books.